The Federal Reserve has been fighting high inflation for two years, and now bond market investors have discovered a new danger: inflation may fall below the Fed's target level.

On Tuesday, September 10, Eastern Time, the 10-year breakeven inflation rate reflected in U.S. Treasury bonds fell to 2.02%, the lowest closing level since 2021. This indicates that investors expect the average inflation rate over the next decade to be below the Federal Reserve's 2% inflation target. Historical records show that the CPI is usually about 40 basis points higher than the PCE price index, the inflation indicator favored by the Federal Reserve.

The breakeven inflation rate is calculated from the spread between Treasury Inflation-Protected Securities (TIPS) and standard U.S. Treasury bonds. The decline in this indicator stems from the fact that the yield on nominal U.S. Treasury bonds has fallen faster than that on TIPS. For the Federal Reserve, the inflation implied by this indicator being below the target is certainly not good news. The Fed has long believed that persistently low inflation is as harmful to the economy as rising prices because it forces the central bank to keep borrowing costs too low for too long, thereby weakening the Fed's ability to combat economic recessions.

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Tim Duy, Chief U.S. Economist at SGH Macro Advisors, commented that market participants feel that the surge in inflation has now completely ended, and the risk has shifted to employment. The Fed's efforts to reduce inflation may be excessive, and now "this risk must be taken very seriously."

Some strategists believe that in addition to the downward trend in U.S. Treasury yields, the decline in the breakeven inflation rate is also affected by factors such as the low liquidity of TIPS linked to U.S. inflation and the recent sharp drop in oil prices. However, they warn that the breakeven inflation rate indicates that investors are concerned that the Fed's easing monetary policy may be too slow.

Federal Reserve Chairman Powell sent a dovish signal in his speech at the Jackson Hole central bank annual meeting in August. The market currently widely expects that the Fed's monetary policy committee, the FOMC, will decide to cut interest rates at this month's meeting. The market's disagreement lies in how quickly the rate cut can be made to avoid an economic recession. Interest rate swap contract prices show that traders have fully digested the possibility of a 25 basis point rate cut by the Fed this month, and the possibility of a 50 basis point rate cut is only 20%.

In addition to the long-term inflation outlook, Angelo Manolatos, a strategist at Wells Fargo Securities, pointed out that the short-term inflation expectations in the inflation swap contracts are more severe. The one-year swap contract indicates that traders are betting that the CPI will only rise by about 1.7% over the next 12 months, while economists expect the U.S. August CPI to be announced this Wednesday to grow by 2.5% year-on-year, slowing down from 2.9% in July, and far below the peak of 9.1% in June 2022.

Manolatos said that these trends indicate that the pricing in the U.S. Treasury market is reflecting an increased risk of a hard landing. Even when the CPI was as high as 9% a few years ago, there was no premium for inflation risk.

Some strategists believe that the recent decline in the breakeven inflation rate is excessive and too rapid. Michael Pond, a strategist at Barclays, advised clients to position in the forward market for a steeper breakeven curve, stating that investors have underestimated the longer-term inflation risk. Societe Generale strategists advised clients to bet on a rise in the five-year breakeven rate, noting that even in a recession, it is rare for the five-year CPI inflation to fall below 2%, with the probability of this happening only 2% since 1945.

Last Friday, former Treasury Secretary Summers, a U.S. high inflation whistleblower, said that the U.S. August non-farm employment report released that day was not particularly bad, and the report data certainly did not show significant weakness. He currently expects that the U.S. will not fall into a recession. Wall Street Journal subsequently mentioned that if this is indeed the case, then the financial market's expectations for future Fed easing are too high.Last Friday, the two-year U.S. Treasury yield, which is sensitive to interest rate movements, fell below 3.60% during the session, reaching a new low since the collapse of Silicon Valley Bank in March last year, which triggered a crisis in the American banking industry.